Terror futures: Why Pentagon betting is good

"Appalling," " repugnant," and "incredibly stupid" were a few of the choice words used by two U.S. senators, Byron Dorgan (D-ND) and Ron Wyden (D-WA) over a Pentagon proposal to create a futures market aimed at predicting events in the Middle East.

Senate Democratic leader Tom Daschle chimed in, "I must say this is perhaps the most irresponsible, outrageous, and poorly thought-out of anything that I have heard the administration propose to date."

In reaction, an embarrassed Defense Department swiftly canned the project. What nefarious activity is the Pentagon up to? Creating an online betting parlor to enable insider traders at the Defense and State Departments to feather their retirement nests? Hardly.

The senators are objecting to a pilot project by the Defense Advanced Research Projects Agency (DARPA) called the Policy Analysis Market (PAM). As the PAM website explains: "Analysts often use prices from various markets as indicators of potential events. The use of petroleum futures contract prices by analysts of the Middle East is a classic example. The Policy Analysis Market (PAM) refines this approach by trading futures contracts that deal with underlying fundamentals of relevance to the Middle East. Initially, PAM will focus on the economic, civil, and military futures of Egypt, Jordan, Iran, Iraq, Israel, Saudi Arabia, Syria, and Turkey and the impact of U.S. involvement with each." The Pentagon envisioned enrolling 10,000 traders by October at a cost of $8 million to set it up.

The PAM concept is the brainchild of George Mason University economics professor Robin Hanson, who has been working on the concept of "ideas futures" for years and is in fact working with the DARPA subcontractor that devised the PAM.

"Look, intelligence is about spending money in order to find out information about gruesome things like war and terrorism," says Hanson. "This is just an alternative institution that tries to aggregate intelligence information... It's a research project and it might not work, but there is a lot of history and data showing how effective markets are at predicting events."

To illustrate how PAM might work, Senator Wyden offered a scenario in which a bidder thinks early on that Prime Minister X is going to be assassinated. So she buys the futures contracts for 5 cents each. As more people begin to think the person's going to be assassinated, the cost of the contract could go up, to 50 cents.

"The payoff if he's assassinated is $1 per future," noted Wyden. "So if it comes to pass, those who bought at 5 cents make 95 cents. Those who bought at 50 cents make 50 cents." Of course, those who bet the other way lose their money. What Wyden is ignoring is that while market participants are making and losing money, it's possible that our intelligence agencies have gained some valuable information to help our leaders formulate appropriate policies such as what to do if Prime Minister X is assassinated.

So why not harness the predictive power of markets for intelligence purposes? Markets have demonstrated time and time again that people have a lot of dispersed and hidden information that the prospect of profit can lure into the open.

For example, futures markets similar to PAM already operate with real money in the real world and have proved themselves to be very useful. "The Iowa Electronic Markets provide more accurate election results than do opinion polls; weather futures markets are better at predicting weather than the National Weather Service," says Hanson. Do Senators Wyden and Dorgan find it "disgusting" that people with lots of money to lose protect themselves by betting on whether Florida will get hit by a hurricane? (By the way, being Democrats, they both might want to consult the Iowa Electronics' Democratic Presidential Nomination futures, where Richard Gephardt futures have fallen to the basement while Rest of Field (ROF) futures now lead, probably reflecting the boom in Howard Dean futures.)

The PAM website offered example contracts (apparently pulled in deference to the Senators' delicate sensibilities) in which traders would bid on things such as the likelihood that the King of Jordan would be overthrown, that Yasser Arafat would be assassinated or that North Korea would launch a missile attack. This is very interesting information which clearly our political and defense leaders, including Senators Wyden and Dorgan, would want to know.

In fact, there already are quasi-markets in such information offered by Tradesports.com under its current events markets. For example, there were Tradesports.com futures contracts on whether Iraqi weapons of mass destruction would be found by the end of July. The market is rather bearish since those July WMD contracts ended up selling for just $5 down from a high of $29. Could it be that that low bid might tell us something about the value of "intelligence" gathered the old fashioned way? Tradesports offers contracts on whether Osama bin Laden will be captured by the end of September. They are up from their lows of $14 to $20, but still way down from their high of $69.

"Why wouldn't terrorists just hop online and start betting if they couldn't either mislead American authorities about their plans or make money to fund more al Qaeda operations?" Wyden asked. Why not indeed? If terrorists were trying to use PAM to make money that "would mean that they are giving up information to gain money," says Hanson. "In other words, we're bribing them to tell us what they are going to do. That's kind of like normal intelligence gathering when we bribe agents for information."

But what about terrorists using PAM bids to mislead our intelligence agencies? Markets are very good at dealing with that problem, insists Hanson.

"There are already lots of people who have an interest in obscuring information in markets," says Hanson. "There are CEOs who want to make their company's performance look better than it is to boost its stock prices, or the president of a South American country who wants to make his country's prospects look good to keep exchange rates high." In the long run, they lose money and provide higher profits to those with superior information.

Consider this scenario. Let's say PAM offers a futures contract on a pool of 50 Middle Eastern leaders, and we know that on average one of them gets killed every year. If assassination is random, that means that each one has a two percent chance of being dead in the next year. Prices that move away from two percent indicate that the market participants anticipate a greater or lesser likelihood that any particular leader would be killed.

Say terrorists flood the market with bids on assassinating Egyptian President Hosni Mubarak so that the prediction rises to four percent. Why would they do that? To direct our attention away from one of the other 49 leaders that they are actually targeting? That doesn't get them a lot of misdirection. And other market participants would still be bidding on other likely candidates for assassination and would take the profits away from the terrorist bidders when Mubarak attends the next Arab summit meeting a year later.

The PAM also offers another interesting feature– it allows bids on contingencies. For example, one contract might consider the chances of a Saudi Arabian coup in the next year if American troops remain stationed there. Another might ask what are the chances of a coup if they leave? If a U.S. pullout reduces the likelihood of a coup 10 percent to 5 percent, that would be interesting information.

In the end, a promising research program that might have enhanced U.S. intelligence gathering was killed off by cheap moral posturing on the part of a couple of U.S. senators. Who's incredibly stupid now?

Downtown Charlottesville resident Ronald Bailey is the science correspondent for Reason, the magazine where this essay– now distrubuted by the Featurewell service– first appeared.